DBRS Morningstar Confirms Colombia at BBB, Trend Remains Negative

DBRS, Inc. (DBRS Morningstar) confirmed the Republic of Colombia’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB. At the same time, DBRS Morningstar confirmed the Republic of Colombia’s Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (high). The trend on all ratings remains Negative.

KEY RATING CONSIDERATIONS

The Negative trend reflects the ongoing deterioration in Colombia’s sovereign credit profile due in part to the adverse effects of the pandemic on Colombian public finances. The IMF projects that general government debt increased over 10 percentage points of GDP in 2020. Putting public finances on a sustainable path will require a sizable fiscal adjustment. The BBB ratings assume a fiscal reform is passed in the near term that raises revenue and underpins a structural consolidation once the health crisis subsides. Passage of the reform, along with the reinstatement of a modified structural deficit rule, would limit the expected deterioration in public finance metrics, help anchor market confidence, and enable authorities to rebuild fiscal space over time. Upcoming elections in 2022 suggest a limited timetable for passing fiscal reforms; consequently, the absence of a credible fiscal adjustment plan over the next few months will likely result in a downgrade of the ratings.

The COVID-19 shock has had a severe impact on Colombia in terms of health and economic outcomes. The economy contracted 6.8% in 2020 due to pandemic-related restrictions, lower commodity prices, and weak regional demand. Localized lockdowns in January 2021 dampened growth momentum at the start of this year and the recent rise in COVID-19 cases could portend another round of restrictions. Nevertheless, the recovery should accelerate once the pandemic is contained. The government purchased enough vaccines to cover almost the entire adult population. Distribution started in February and the rollout is expected to ramp up over the next 4 months. The gradual reopening of the economy, combined with higher oil prices, accommodative macroeconomic policies, and favorable global financing conditions should support the recovery. The economy is expected to grow 5.1% in 2021 and 3.6% in 2022.

However, there is a high degree of uncertainty around the economic outlook. The spread of the virus, especially more contagious variants, or potential delays in the vaccination drive pose downside risks to the recovery. Colombia’s sizable external financing needs also leave the economy vulnerable to tighter global financing conditions. In addition, the recovery in the post-pandemic period could underperform expectations, particularly if the pandemic has longer-lasting effects on the labor market.

The BBB ratings balance Colombia’s increasing fiscal challenges with its sound macroeconomic policy framework. Colombia has benefited from low and stable inflation since instituting a credible inflation-targeting regime more than two decades ago. This has been accompanied by exchange rate flexibility and sound regulation of financial sector. With strong policy frameworks, Colombia has been able to mitigate the effects of the pandemic on the economy with expansionary fiscal and monetary policies, exchange rate flexibility, and prudential measures to support the supply of credit. Infrastructure development and the integration of Venezuelan migrants into the economy should also support the country’s growth outlook over the medium term.

RATING DRIVERS

Colombia’s rating are unlikely to be upgraded in the near term. In the medium term, however, the ratings could be upgraded if fiscal accounts are consolidated in a durable manner and supply-side improvements in the economy raise growth prospects.

The trend could be changed to Stable if the government puts in place a credible fiscal adjustment plan that is underpinned by the passage of a revenue-raising tax reform and the reinstatement of a modified structural fiscal rule.

The ratings could be downgraded if 1) the government fails to pass fiscal reforms in the near term that put public finances on a sustainable trajectory, or 2) scarring effects on the economy from the COVID-19 shock prove to be deeper or longer lasting than currently expected.

RATING RATIONALE

Fiscal Policy Is Delivering Temporary Support But Structural Consolidation Requires Fiscal Reform

The fiscal response to the pandemic has focused on additional healthcare spending and financial relief for households and businesses. The general government deficit increased from 2.6% of GDP in 2019 to 7.0% in 2020, and it is expected to reach 8.3% of GDP in 2021. The widening of the deficit this year is primarily due to the rolling over of unspent pandemic-related funds budgeted for last year into emergency programs for 2021, including vaccine procurement, as well as greater public investment. Fiscal results in 2021 will also be negatively impacted by lower oil-related revenue (i.e. corporate income taxes and Ecopetrol dividends), on account of lower oil prices in 2020.

Once the health crisis subsides, a structural fiscal adjustment is needed to put public finances on a sustainable path. The deficit will narrow as emergency spending expires and the cyclical recovery advances, but additional effort will be needed. To address this, the Duque administration is presenting a fiscal reform to Congress this month. The proposal is expected to: 1) raise tax revenues by 2.2 percentage points of GDP, largely by eliminating exemptions in the VAT and increasing taxes on higher income individuals, and 2) increase spending by 0.8 percentage points, primarily by expanding social transfers to low-income households. The net fiscal adjustment would be 1.4 percentage points of GDP, and the reform would take effect in 2022 and 2023. While revenue mobilization is essential to restore fiscal sustainability, it is insufficient. It will be equally important to redesign the structural deficit rule, which was suspended in 2020 and 2021 to accommodate emergency spending, so as to reinforce the credibility of the multi-year consolidation and provide a sustainable fiscal anchor over the medium term.

One consequence of the COVID-19 shock is markedly higher government debt. The IMF projected in March 2021 that general government debt will increase from 52.3% of GDP in 2019 to 62.8% in 2020. The 10.5 percentage point of GDP increase is due to a large fiscal deficit, the sharp contraction in GDP, and peso depreciation. The debt-to-GDP ratio will rise to 64% in 2021, but will gradually decline as a durable fiscal adjustment is implemented and the economy expands at an above-trend pace. The composition of the debt is generally favorable, with a long average maturity structure and almost all liabilities carrying fixed rates. Nevertheless, over one-third of the debt is denominated in foreign currency, leaving the balance sheet exposed to peso depreciation. Key risks to the outlook stem from weaker-than-expected growth – either in near term or in the post-pandemic period – and fiscal underperformance. Debt dynamics could materially deteriorate if fiscal inaction leads to weaker market confidence and higher interest costs.

Expansionary Monetary Policy Is Supporting The Recovery Amid Benign Inflation Dynamics

The central bank will likely retain an accommodative monetary policy stance until the recovery firmly takes hold and the large output gap narrows. Price pressures are modest and inflation expectations remain anchored. Core inflation was 1.2% in February 2021, slightly below the lower bound of the central bank’s target range. In the initial stages of the COVID-19 shock, the central bank cut the policy rate and provided ample foreign and local currency liquidity to the financial system. The easing cycle, which lasted through September 2020, cumulatively amounted to 250 basis points, and the cuts were largely passed on to individual and corporate borrowers. At the same time, the extraordinary liquidity measures were effective, as financial markets functioned well in the aftermath of the shock.

The financial regulator also eased regulations so Colombian banks could continue to deliver credit to the economy while providing temporary forbearance to borrowers. The scale of the temporary forbearance has narrowed over time. Forty-three percent of bank loans by value were granted some form of relief by July 2020. By the time the relief period expired in January 2021, the vast majority of loans had resumed repayment. More targeted regulatory relief started in August 2020 and will remain in effect until June 2021. About 6% of loans by value are covered under this program. Banks increased provisioning to cover lost interest revenue and expected credit losses, which led to lower profitability. Nevertheless, the banking system has demonstrated resilience, thus far. Despite higher costs stemming from forbearance and weaker credit quality, banks were still profitable in 2020. Asset quality indicators could deteriorate further, especially if the recovery is delayed, but banks are relatively well-capitalized, which gives them space to absorb unexpected credits costs in a moderately adverse scenario.

The Economy Is Set To Recover But Potential Growth Is Moderate And External Accounts Pose A Vulnerability

The pace of the economic recovery over the next 3-9 months will depend in large part on the evolution of the virus and the pace of vaccine distribution. Once the pandemic is contained and restrictions are eased, Colombia’s growth prospects are good compared to regional peers. Pent-up demand and supportive macroeconomic policies will help to gradually close the output gap. The IMF expects output to be 14% above 2019 levels by 2025. Although this does not imply a strong cumulative growth performance from 2019 to 2025, it highlights Colombia’s resilience compared to others in the region. Among Latin America’s largest economies, only Peru is expected to reach a similar output level relative to 2019. Colombia’s economic resilience accounts for the one category uplift in our assessment of the Economic Structure and Performance building block.

Colombia’s potential growth rate is estimated at around 3 percent, which is slightly lower than the country’s historical growth record. Reforms to the supply side of the economy would help to boost productivity growth and capital accumulation. Notwithstanding significant advances in the government’s fourth-generation infrastructure program and the announcement of the fifth-generation plan, Colombia’s large infrastructure gap remains a major impediment to growth. Underdeveloped infrastructure increases transportation costs, thereby limiting access within the domestic market and acting as an obstacle to international competitiveness. In addition, Colombia’s labor market is characterized by high structural unemployment and widespread informality. A sustained period of labor underutilization in the aftermath of the pandemic could have scarring effects on the economy, as workers lose skills or drop out of the labor force. Finally, the economy is relatively closed and, therefore, does not fully benefit from the potential efficiency gains derived from greater integration into global markets. Strengthening the country’s growth prospects will depend in part on the government’s ability to advance a comprehensive agenda that addresses these interlinking constraints.

One medium-term growth opportunity stems from the massive migration from Venezuela. In February 2021, the Duque administration announced it would grant Temporary Protection Status to more than 1.7 million Venezuelans that fled the economic depression and political unrest in their country and are now living in Colombia. The decision to provide legal status for 10 years should help integrate new arrivals into the Colombian economy and facilitate the delivery of public services. While the scale of the migration has added to budgetary pressures, the increase in the labor force should boost potential GDP. If two-thirds of the Venezuelan migrants that have already arrived are between the ages of 14 and 65, the working age population in Colombia would increase by about 1.1 million, or by 3% relative to the 2015 level.

While Colombia’s growth prospects are better than most in the region, the country’s external imbalances expose the economy to capital flow volatility in the near term. Amid the pandemic, Colombia’s credible macroeconomic policy framework and flexible exchange rate helped the economy rebalance in an orderly manner. The current account deficit narrowed from 4.4% of GDP in 2019 to 3.3% in 2020, as lower imports and profit repatriation more than offset lower commodity export receipts. The deficit was largely financed with a mix of net direct investment, portfolio flows into government debt securities, and public sector borrowing from the international bond market and multilateral lenders. Reserves increased $5.9 billion during 2020 (including valuation effects). As a result, Colombia ended the year with $59.0 billion in reserves as well as a Flexible Credit Line with the IMF ($12.2 billion available after the drawdown of $5.4 billion in December 2020), which provide the economy with some protection against global downside risks. Nevertheless, with the current account expected to widen modestly as domestic demand strengthens and an elevated level of private external debt maturing over the next 12 months, gross external financing needs will remain relatively high. If global financing conditions deteriorate, capital inflows could slow or even reverse, and the resulting adjustment would likely entail strong import compression and slower growth.

Institutional Quality Is A Key Credit Challenge; Duque Aims to Pass Tax Reform In A Difficult Political Climate

DBRS Morningstar views the issue of institutional quality in Colombia as a credit challenge. There has been positive news for the country in terms of governance in recent years: Colombia has continued to deliver sound macroeconomic management, the peace accord with the FARC is advancing, despite some setbacks, and the homicide rate is near its lowest level in at least 30 years. Moreover, Colombians’ participation in the democratic process has strengthened over the last decade, according to World Bank Governance Indicators. However, a key governance challenge is the rule of law, where Colombia compares unfavorably to most similarly rated countries. The process of extending the state’s presence to remote areas of the country, reintegrating thousands of former combatants into society, and addressing criminal activity tied to narcotics trafficking remain long-term challenges.

With President Iván Duque approaching his last year in office, his administration aims to pass a tax reform, which we view as critical to maintain the country’s BBB credit rating. However, it is unclear if the President will be able to build a coalition in congress large enough to pass the reform, especially given the divided nature of congress, the government’s focus on the vaccine rollout, and the political class eyeing upcoming elections. Congressional elections are scheduled for March 2022, and the first round of the presidential election will be held two months later.

The contours of the 2022 presidential election will form over next 12 months. Candidates span the ideological spectrum. There are many potential candidates in the center and on the right but no clear frontrunner. The prospect of a leftist such as Gustavo Petro winning the presidency could lead to market volatility in the run up to the election. However, the two-round structure of presidential elections in Colombia typically increases the likelihood of a centrist or right-of-center candidate winning the election. Petro leads most early polls, but he is well short of a majority and he could have a hard time coalescing the center-left under his leadership.

ESG CONSIDERATIONS

Resource & Energy Management (E), Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), Institutional Strength, Governance & Transparency (G), and Peace & Security (G) were among key drivers behind this rating action. The economy is vulnerable to oil price shocks, with petroleum products constituting roughly 1/3 of Colombia’s exports, 20% of foreign direct investment inflows, and 5-10% of government fiscal revenues. Similar to other emerging market economies and many of its regional peers, Colombia’s GDP per capita is relatively low at US$5.2k (US$14.1k on a PPP basis). This largely reflects the low level of labor productivity. In addition, organized criminal gangs continue to commit human rights abuses, especially against journalists, community leaders, and human rights activists. According to World Bank Governance Indicators, Colombia ranks in the 49th percentile for Control of Corruption, the 56th percentile for Voice & Accountability, and the 56th percentile for Government Effectiveness. While Colombia has made significant progress in reducing violence through a peace deal with the FARC, the country still ranks very low (16th percentile) on Political Stability and the Absence of Violence/Terrorism, and ranks in the 39th percentile for Rule of Law. These considerations have been taken into account within the following Building Blocks: Fiscal Management and Policy, Economic Structure and Performance, Balance of Payments, and Political Environment.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/376261.

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883

All figures are in U.S. dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstarcriteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.

The primary sources of information used for this rating include the Ministerio de Hacienda y Crédito Público, Banco de la República, Superintendencia Financiera de Colombia, DANE, IMF, UNDP, Tullet Prebon Information, World Bank, NRGI, Brookings, BIS, World Federation of Exchanges, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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